Misunderstanding Economic Profit
Small misunderstandings can snowball into major confusions. This is as true in economics as in any other field. Very often one finds a well-educated person build up a sophisticated analysis that ultimately rests on a misunderstanding of basic economics. Marx wrote thousands of pages of economic prophecy that rested on the false foundation of the labor theory of value. Modern observers are no less vulnerable.
I was reminded of this when reading a book review by Scott Alexander of Peter Theil’s Zero to One. Peter Theil spends a lot of intellectual effort trying to explain something which, to him, cries out for an explanation, but seems to rest on a fundamental misunderstanding of what economists mean when talking about profit.
According to the Scott Alexander’s review, “the basic economic argument goes like this: In a normal industry (eg restaurant ownership) competition should drive profit margins close to zero.” But this leads to the following mystery: “Neither the promise nor the warning has been borne out: business owners are often comfortable and sometimes rich.” To Theil, this is a contradiction between theory and reality that must be explained. Theil attempts to explain it by suggesting that wealthy businesses have “escaped competition and become at least a little monopoly-like.”
But Theil is attempting to resolve a contradiction that doesn’t exist. Here’s where the misunderstanding lies. Economic theory does not predict that competitive markets will drive profit margins close to zero. What economic theory tells us is that competitive markets will drive the rate of economic profit towards zero. This may sound like two slightly different ways of saying the same thing, but there is a big difference between them.
When most people think of profits, they think of accounting profits – income minus expenses, in the simplest formation. And this isn’t unreasonable – it describes what most people care about in their day-to-day life. Am I bringing in more money than I’m spending? If so, I’m profitable, and if not, I’m taking losses. But economic profits also consider the opportunity cost – that is, it factors in what else you could be doing.
To put it another way, economic profits are the difference between your current choice and the best available alternative. Because of this, your economic profits can be low, zero, or even negative while you are making large accounting profits. If your next available option is just as good as your current situation, then you’re making zero economic profits- even if you have a very favorable cash flow. If your best alternative is only slightly worse than the status quo, you’re making a small economic profit. If there’s a better option for you out there, then you’re sustaining an economic loss, even if your bank account is very impressive.
Consider this example. Suppose I can assign some square footage in a building I own to gambling. Let’s say I put in a bunch of nickel slot machines. Imagine that these machines are very popular – all day, every day, there are people sitting at the slot machines, putting in coins and pulling the handles. The money these machines bring in for me exceeds their expenses by $1 million a year. My accounting profits, therefore, are $1 million a year.
But that doesn’t mean I’m making $1 million a year in economic profits. Instead of putting in nickel slots, I could have used that same square footage to put in blackjack tables. If those blackjack tables could have generated accounting profits of $5 million a year, that means the nickel slots carry an annual opportunity cost of $5 million. So even though I’m making accounting profits of $1 million a year with the slot machines, the opportunity cost of not setting up blackjack tables means I’m taking an economic loss of $4 million a year.
In almost all cases, whenever a non-economist decides they’ve made some new, cutting-edge observation that upends standard economic theory, an observation that economists have somehow overlooked, what’s usually going on is the non-economist is just misunderstanding an elementary point. This is one such case. Theil seems to believe that “the rate of economic profit tending towards zero” implies that in competitive markets, every business should be operating on the brink of bankruptcy. He expends a great deal of intellectual effort trying to explain why things haven’t worked out his way. But all his efforts ultimately rest on a misunderstanding of basic economics, and he’s trying to solve a mystery that doesn’t exist. The rate of economic profit tending towards zero just means that your next available option will tend to be nearly as good as your current option. This can be true whether you’re bankrupt, just barely scraping by, comfortably middle class, or a billionaire.